Insight
insights: selections from the Kellogg online
faculty research digest

To
find more articles, including faculty biographies
and suggestions for further reading, or to join
the conversation by leaving your own comments,
visit Kellogg
Insight.

Private
equity — the class of investments that includes venture
capital investments and buyouts — accounts for a relatively
small and, to date, little analyzed percentage of overall
investments. Studies have shown that institutional investors,
such as university endowment funds, corporate and public pension
funds, private advisers, banks and insurance companies generally
outperform individual investors. However, researchers have
unearthed very little information on the success rates of
different types of institutional investors.

Research
conducted by Wan Wongsunwai, senior lecturer in accounting
information and management at the Kellogg School, with co-authors
Josh Lerner (Harvard Business School) and Antoinette Schoar
(Massachusetts Institute of Technology), has changed that.
The team studied previously unexplored records of portfolio
composition and fund performance and found large disparities
in private equity investment performance among different institutions.

Between
1991 and 1998, the best performers by far were endowment funds
run by universities and foundations. Funds in which endowments
invested showed, on average, a 44 percent internal rate of
return (IRR). In contrast, investments by private advisers
showed a 23 percent IRR, and those by public pension funds
20 percent IRR. Corporate pension funds and banks performed
even more poorly, reaching IRRs of 13 percent and just 4 percent,
respectively. An extension of the analysis through 2001 —
covering a period when returns from many funds were at best
mediocre — reveals even greater differences. No noticeable
changes in those results were caused by correcting for factors
such as the time in which the investments were made and the
choice between venture capital investments and buyouts.

The
team expected to find some variation among different types
of investors in private equity, based on anecdotal evidence.
For example, they knew that several academic endowment fund
managers had spent years earning high returns. However, the
sharp contrast between endowment funds and the others was
a surprise.

What
causes the marked performance differences? Wongsunwai and
his colleagues examined the possibilities. First, different
types of investors might prefer different risk profiles for
the funds in which they invest. Certain investors, such as
banks, might use their investment as kinds of "loss leaders."
Wongsunwai explains: "Banks don't invest in private equity
only to generate returns, but [also] to get more business."
Second, certain successful private equity funds might limit
access by not accepting new investors, thus allowing only
existing investors to participate, a factor that could favor
long-established endowment funds at the expense of newer investors.

Analysis
showed that those issues have some influence on variations
in performance by different types of institutional investors,
but nowhere near enough to account for the wide gap. However,
the team broke new ground by identifying another factor that
does have a significant impact. "Funds in which endowments
decide to reinvest show much higher performance going forward
than those in which endowments decide not to reinvest,"
the team reported in The Journal of Finance. "This
suggests that endowments proactively use the private information
they gain from being an inside investor, while other [institutional
investors] seem less willing or able to use information they
obtain as an existing fund investor."

Why
should endowments make better reinvestment decisions than
other institutional investors? "This might be an access
story of a different kind," Wongsunwai speculates. "It's
a matter of relationships that involve private equity players
who might, for example, be alumni on the boards of university
endowment funds. It's an old boy network."

The
team quickly found a good reason for the lack of research
on the issue: unlike public companies, private equity organizations
reveal very little detail about their financial situations.
"The disclosure of performance in the private equity
business is tricky; the information is not exactly publicly
available," Wongsunwai points out. "Some investors
and even private equity firms themselves occasionally provide
the information, but so far this is not a widespread trend."

What
advice does Wongsunwai have for private equity investors?
Don't just chase returns, and beware of funds required to
invest locally. "Successful investors seem to know when
to terminate relationships with fund managers based not only
on how well they have done in the past but also — and
more importantly — how well they are expected to do
in future," he says.